Definition

The financial accounting term last-in, first-out refers to one of several acceptable approaches to inventory valuation. The last-in, first-out method assumes the newest items held in inventory are the first items to be sold when determining the value of this asset as it appears on a company's balance sheet.

Explanation

Also referred to as LIFO, the last-in, first-out method assumes the newest items held in stock are the first items to be sold. This is an assumption used to value the company's inventory; the physical flow of items from inventory may differ from this valuation technique.

While this approach might seem counter-intuitive, there are strong arguments that support the LIFO method. Proponents of LIFO believe that income values should be based on current market costs. That is to say, current revenues should be aligned with current costs.

Accurate inventory valuation will ensure the proper reporting of assets on the company's balance sheet. It's also important to understand the ending inventory value for one year is the beginning inventory value in the following year. Inventory errors likewise have an effect on net income. For example, if the beginning inventory is understated, net income in that period will be overstated.

Example

The following table illustrates the LIFO approach to valuing inventory. Company A begins the year with 250 units, adds 400 units throughout the year, and sells 500 units. The ending inventory for Company A is 150 units.

Units

Cost per Unit

Total Cost

Beginning Inventory

250

$700

$175,000

Additions on March 1

100

$725

$72,500

Additions on June 1

100

$750

$75,000

Additions on September 1

100

$775

$77,500

Additions on December 1

100

$800

$80,000

Goods Available for Sale

650

$480,000

Units Sold

500

Units from Beginning Inventory

150

$700

$105,000

Ending Inventory

150

$105,000

The above ending inventory of $105,000 can be used along with the cost of goods available for sale ($480,000) to determine the Cost of Goods Sold: